Nov 17, 2016 4 min read

This week, we will discuss investing in bonds.

First, let’s talk about the difference between stocks and bonds. Stocks are an ownership interest in a company. They may pay dividends, but often the gain comes from price appreciation. This is when a company’s value grows because of increased sales and profits. When you buy a bond in a company, you are lending them your money for a specific length of time.

If a company were to go bankrupt, bondholders would be paid back before stockholders. Stocks do not have an ending date like bonds. Stockholders get to vote for company officers while bondholders usually do not. The market value of stocks change often depending on investor demand. Bond prices can vary in value based on interest rates and duration. Duration is how long until a bond matures. At maturity, a company pays off the bond face value, and it is surrendered back to the company.

Bonds were often considered the safe part of an investment portfolio. This widely held view may be a mistake. This viewpoint is that bond prices are stable, since they do not change and they pay a certain dividend rate. Bonds investments have performed well for the last 15 years or so. This could be about to change because bonds have had a strong tailwind behind them during this time frame.

During this time, interest rates have been held at near zero by the Federal Reserve. Bond values move in an inverse motion than interest rate. This means that longer term bonds that were issued 15 or 20 years ago, paid higher interest rates than bonds issued more recently. Because of this, investors were willing to pay a premium over the bonds face value. This is because they would be earning higher interest rate. At maturity, the bond will be redeemed at face value. This adjustment and increased earnings are mathematically factored in the premium that the buyer would be willing to pay.

The quantitative easing that the Fed employed also made older bonds more valuable. Federal bonds are sold at auction with the buyer willing to accept the lowest interest rate being the one who wins the bid. The Fed controls the money printing presses and they have more purchasing power than any other investors. When they were willing to accept basically zero interest, they purchased most of the government bonds. This meant that other bond purchasers were shut out and had to accept lower interest rates on company bonds. All of these actions made older higher interest paying bonds more valuable.

Today, we are seeing the tailwinds changing to headwinds. Most older bonds are maturing so there are fewer options to invest in. The Fed is no longer buying the massive quantity that they did during the quantitative easing. At some point the Fed may have to begin selling some of their inventory of bonds. This will create more supply than demand and drive prices lower. All of these factors will make many bonds less attractive.

As interest rates start to rise, new bond will have to pay higher interest to get issued. This will make many of the bonds issued over the last few years less attractive. If you own a bond with a lower interest rate, you will continue to receive this income and get your principal back at maturity. However, if you want to receive the higher interest rates, who can you sell your current bond too? Not the company that issued it. They will not buy back a lower interest bond to replace it with one that will cost them more. Another potential investor will not be willing to pay you face value for your bond to earn less. They will only buy yours if you offer a discount. This discount must return the new investor the new higher interest rate. The longer the duration to maturity, the bigger the discount must be.

This means as the Fed begins to raise interest rates the value of your portfolio will go down if you need to raise capital. Bonds will not provide the safety that many people believe. Last week’ election of Donald Trump increases the chances of interest rate rising quickly. This is because now with Congress and the presidency controlled by the same party there will be less gridlock. This will increase the chances for fiscal stimulus of the economy and more inflation.

Your Financial Future is written by certified financial planner Gary W. Boatman, MBA and CFP, who also wrote the book, “Your Financial Compass: Safe Passage Through The Turbulent Waters of Taxes, Income Planning and Market Volatility.”